chapter 19

Bank Goals, Strategy, and Governance (2 of 4)

Bank Governance by the Board of Directors Some of the more important functions of bank directors are to: •Determine a compensation system for the bank's executives. •Ensure proper disclosure of the bank's financial condition and performance to investors. •Oversee growth strategies such as acquisitions. •Oversee policies for changing the capital structure, including decisions to raise capital or to engage in stock repurchases. •Assess the bank's performance and ensure that corrective action is taken if the performance is weak because of poor management.

Bank Goals, Strategy, and Governance (3 of 4)

Bank Governance by the Board of Directors (cont.) •Inside versus Outside Directors •Board members who are also managers of the bank (i.e. inside directors) may sometimes face a conflict of interests because their decisions as board members may affect their jobs as managers. •Outside directors (directors who are not managers) are generally expected to be more effective at overseeing a bank: They do not face a conflict of interests in serving shareholders.

Which of the following is not an advantage of a bank acquisition? a. An acquiring bank may have some managerial advantages over a target, which should allow the acquirer to improve the target's performance after the acquisition. b. Bank acquisitions can remove redundant operations. c. Some banks may be able to achieve economies of scale by acquiring other banks. d. Bank acquisitions can achieve diversification benefits as the acquirer can offer loans in some new industries. e. All of these choices are advantages of bank acquisitions.

e

Managing Liquidity (2 of 3)

Management of Money Market Securities •Banks can ensure sufficient liquidity by using most of their funds to purchase short-term Treasury securities or other money market securities. •Banks must be concerned about achieving a reasonable return on their assets, which often conflicts with the liquidity objective. A proper balance must be maintained. Management of Loans •The secondary market for loans has improved the liquidity, however this liquidity may lessen as economic condition lessens and demand for selling loans increases.

Managing Credit Risk (2 of 6)

Measuring Credit Risk (cont.) •Measuring Credit Risk of a Bank Portfolio •Exposure is dependent on types of loans a bank provides. •Larger proportion of financing credit cards increases exposure to credit risk. •Exposure also changes over time in response to economic conditions.

Managing Credit Risk (1 of 6)

Measuring Credit Risk: Banks employ credit analysts who review the financial information of corporations applying for loans and evaluate their creditworthiness. •Determining the Collateral •When a bank assesses a request for credit, it must decide whether to require collateral that can back the loan in case the borrower is unable to make the payments. •Determining the Loan Rate •If the bank decides to grant the loan, it can use its evaluation of the firm to determine the appropriate interest rate. •Some loans to high-quality (low-risk) customers are commonly offered at rates below the prime rate.

Managing Interest Rate Risk (2 of 10)

Methods Used to Assess Interest Rate Risk •Gap Analysis — Banks can attempt to determine their interest rate risk by monitoring their gap over time (Exhibit 19.4), where: Gap = Rate-sensitive assets - Rate-sensitive liabilities •An alternative formula is the gap ratio, which is measured as the volume of rate sensitive assets divided by rate-sensitive liabilities. •Many banks classify interest-sensitive assets and liabilities into various categories based on the timing in which interest rates are reset.

Managing Interest Rate Risk (8 of 10)

Methods Used to Reduce Interest Rate Risk •Maturity Matching — Match each deposit's maturity with an asset of the same maturity. •Using Floating-Rate Loans — Allows banks to support long-term assets with short-term deposits without overly exposing themselves to interest rate risk.

Managing Interest Rate Risk (9 of 10)

Methods Used to Reduce Interest Rate Risk (cont.) •Using Interest Rate Futures Contracts •Interest rate futures contracts lock in the price at which financial instruments can be purchased or sold on a specified future settlement date. •Financial futures contracts can reduce the uncertainty about a bank's net interest margin. (Exhibit 19.6) •Using Interest Rate Swaps — An arrangement to exchange periodic cash flows based on specified interest rates. (Exhibits 19.7 & 19.8)

Managing Interest Rate Risk (1 of 10)

Net Interest Margin (spread) is the difference between interest payments received and interest paid: Net interest margin = (interest revenues - interest expenses)/assets During a period of rising interest rates, a bank's net interest margin will likely decrease if its liabilities are more rate sensitive than its assets. (Exhibit 19.2) The deposit rates will typically be more sensitive if their turnover is quicker. (Exhibit 19.3) A bank measures the risk and then uses its assessment of future interest rates to decide whether and how to hedge the risk.

Bank Goals, Strategy, and Governance (4 of 4)

Other Forms of Bank Governance •Publicly traded banks are subject to potential shareholder activism. The market for corporate control serves as a form of governance because bank managers recognize that they could lose their jobs if their bank is acquired

Managing Credit Risk (5 of 6)

Reducing Credit Risk •Industry Diversification of Loans — Banks should diversify their loans to ensure that their customers are not dependent on a common source of income. •International Diversification of Loans — Many banks reduce their exposure to U.S. economic conditions by diversifying their loan portfolio internationally.

Managing Credit Risk (6 of 6)

Reducing Credit Risk (cont.) •Selling Loans — Banks can eliminate loans that are causing excessive risk to their loan portfolios by selling them in the secondary market. •Revising the Loan Portfolio in Response to Economic Conditions — Banks continually assess both the overall composition of their loan portfolios and the economic environment.

Managing Liquidity (1 of 3)

•Banks can experience illiquidity when cash outflows (due to deposit withdrawals, loans, etc.) exceed cash inflows (new deposits, loan repayments, etc.). Management of Liabilities •They can resolve cash deficiencies by creating additional liabilities or by selling assets. •Some assets are more marketable than others, so a bank's asset composition can affect its degree of liquidity.

Managing Credit Risk (4 of 6)

Trade-off between Credit Risk and Return •Expected Return and Risk of Subprime Mortgage Loans •Many commercial banks aggressively funded subprime mortgage loans in the 2004-2006 period by originating the mortgages or purchasing mortgage-backed securities that represented subprime mortgages. •The banks did not anticipate the credit crisis that occurred in the 2008-2009 period and that the value of many homes would decline far below the amount owed on the mortgage.

Managing Credit Risk (3 of 6)

Trade-off between Credit Risk and Return •If a bank wants to minimize credit risk, it can use most of its funds to purchase Treasury securities. •A bank concerned with maximizing its return could use most of its funds to provide credit card and consumer loans.

Managing Liquidity (3 of 3)

Use of Securitization to Boost Liquidity •The ability to securitize assets such as automobile and mortgage loans can enhance a bank's liquidity. •The process of securitization involves the sale of assets by the bank to a trustee, who issues securities that are collateralized by the assets. •Collateralized Loan Obligations •Commercial banks can obtain funds by packaging their commercial loans with those of other financial institutions. •Liquidity Problems •Typically preceded by other financial problems such as major defaults on their loans.

Banks could ensure sufficient liquidity by using most of their funds to purchase Treasury securities. a. True b. False

a

Gaston Bank had interest revenues of $70 million last year and $30 million in interest expenses. About $300 million of Gaston's $800 million in assets are rate sensitive, while $600 million of its liabilities are rate sensitive. Gaston Bank's gap is $____. a. -300 million b. 300 million c. -500 million d. 500 million

a

If a bank has a ________ duration gap, its average asset duration is probably ________ than its liability duration. a. positive; larger b. negative; larger c. negative; smaller d. None of these choices are correct.

a

If interest rates ________, banks with ________ duration gaps will be ________ affected. a. rise; positive; adversely b. decrease; negative; positively c. decrease; positive; adversely d. rise; positive; positively e. None of these choices are correct.

a

In a regression of a bank's stock return on an interest rate proxy and market returns, a ________ coefficient for the interest rate variable suggests that bank performance is ________ affected by ________ interest rates. a. negative; adversely; rising b. negative; favorably; rising c. positive; favorably; declining d. positive; adversely; rising e. None of these choices are correct.

a

Parsons Bank reported $3 million in interest revenues and $1 million in interest expenses. Parsons has $20 million in assets and $8 million in liabilities. Parsons net interest margin is ____ percent. a. 10 b. -10 c. 35 d. 25 e. none of the above

a

Some loans to high-quality customers are commonly offered at rates below the prime rate. a. True b. False

a

Sometimes, managers are tempted to make decisions that are in their own best interest rather than shareholder interests. a. True b. False

a

_______ is not a method used to assess interest rate risk. a. Ratio analysis b. Gap analysis c. Duration analysis d. Regression analysis e. All of these choices are methods to assess interest rate risk.

a

A bank can usually simultaneously maximize its return on assets and minimize credit risk. a. True b. False

b

A positive gap (or gap ratio of more than 1.00) suggests that rate-sensitive liabilities exceed rate-sensitive assets. a. True b. False

b

As part of its liquidity management, a bank might a. purchase interest rate swaps. b. issue commercial paper. c. purchase long-term Treasury securities. d. A and C

b

During a period of ________ interest rates, a bank's net interest margin will likely ________ if its liabilities are more rate sensitive than its assets. a. decreasing; decrease b. answers [decreasing; increase] and [increasing; decrease] are correct c. increasing; increase d. increasing; decrease e. decreasing; increase

b

Floating-rate loans completely eliminate interest rate risk. a. True b. False

b

In general, the duration of a bank's zero-coupon securities with short maturities is ____ than the duration of its zero-coupon securities with long maturities. a. higher than b. lower than c. equal to d. A or B, depending on the issuer of the securities

b

Terp Bank obtains a relatively large portion of its funds from conventional demand deposits as it creates many branches with many employees to attract demand deposits. Its interest expenses should be relatively ____, while its noninterest expenses should be relatively ____. a. high; low b. low; high c. high; high d. low; low e. none of the above

b

The Sarbanes-Oxley Act has had little impact on the monitoring conducted by the board members of commercial banks. a. True b. False

b

The boards of directors of banks tend to have fewer directors and a smaller percentage of outside directors than boards of other types of firms. a. True b. False

b

The international debt crisis has demonstrated that diversifying loans among foreign countries guarantees low risk and that loans to foreign governments are risk-free. a. True b. False

b

When cash outflows temporarily exceed cash inflows, banks are most likely to experience a. higher dividend payments. b. illiquidity. c. a negative duration on its assets. d. an excess of capital.

b

Whether a bank has a temporary or a permanent need for funds, the decision should be to borrow in the federal funds market. a. True b. False

b

________ is (are) least likely to be used as a method of reducing interest rate risk. a. Maturity matching b. Stock options c. Interest rate swaps d. Interest rate caps e. Floating-rate loans

b

A ________ gap (or gap ratio ________ than 1.00) suggests that rate-sensitive liabilities ________ rate-sensitive assets. a. positive; less than; exceed b. negative; less than; are less than c. negative; less than; exceed d. negative; greater than; exceed e. None of these choices are correct.

c

Durango Bank has $2 million in rate-sensitive liabilities and $3 million in rate-sensitive assets. Durango's gap ratio is a. $1 million. b. 0.67. c. 1.50. d. None of these choices are correct.

c

If a bank expects interest rates to consistently ________ over time, it will consider allocating most of its funds to rate-________ assets. a. Answers [decrease; sensitive] and [increase; insensitive] are correct. b. decrease; sensitive c. increase; sensitive d. increase; insensitive e. None of these choices are correct.

c

If a bank obtains a relatively large portion of its funds from conventional demand deposits, interest expenses should be relatively ________, while its noninterest expenses should be relatively ________. a. high; low b. high; high c. low; high d. low; low e. None of these choices are correct.

c

In a regression analysis using a bank's stock return, an interest rate proxy, and market returns, a ____ coefficient for the interest rate variable suggests that the bank's performance is ____ affected by ____ interest rates. a. positive; adversely; rising b. positive; favorably; declining c. negative; adversely; rising d. negative; favorably; rising

c

Prussian Bank has assets with an average duration of 2.78 years and liabilities with an average duration of 3.00 years. The market value of Prussian's assets is $100 million, and the market value of Prussian's liabilities is $150 million. Prussian's duration gap is a. 1.17. b. 0.78. c. -1.72. d. 1.72. e. None of these choices are correct.

c

Which of the following statements is not true regarding agency problems between a bank's managers and its shareholders? a. The compensation to a bank's loan officers may be tied to loan volume, which encourages the loan department to provide loans without concern about risk. b. To prevent agency problems, some banks provide stock as compensation to managers. c. Managers are rarely tempted to make decisions that are in their own best interests rather than shareholder interests. d. Decisions that result in growth may be intended to increase employee salaries. e. All of these choices are true with respect to agency problems.

c

Durango Bank has $2 million in rate-sensitive liabilities and $3 million in rate-sensitive assets. Durango's gap is ________, and Durango is probably more concerned about a(n) ________ in interest rates. a. -$1 million; decrease b. $1 million; increase c. -$1 million; increase d. $1 million; decrease e. None of these choices are correct

d

If a bank that relies heavily on short-term deposits expects interest rates to consistently decrease over time, it would allocate most of its funds to loans with ____ rates if it desires to maximize its expected returns. It could reduce its exposure to interest rate risk by setting ____ rates on its loans. a. fixed; fixed b. variable; fixed c. variable; variable d. fixed; variable

d

The risk of a loss due to closing out a transaction is referred to as ________ risk. a. credit b. exchange rate c. interest rate d. settlement e. None of these choices are correct.

d

Which of the following loan portfolios is best diversified against credit risk? a. consumer loans to farmers and commercial loans to farm equipment dealers in a local area b. commercial loans to firms in the same industry c. commercial loans to various retail stores in the same city d. consumer loans and commercial loans to firms in different industries in different cities

d

Bank Goals, Strategy, and Governance (1 of 4)

Aligning Managerial Compensation with Bank Goals Banks may implement compensation programs that provide bonuses to managers that satisfy bank goals. Bank Strategy •A bank's decisions on sources of funds will heavily influence its interest expenses on the income statement. •A bank's asset structure will strongly influence its interest revenue on the income statement. •How Financial Markets Facilitate the Bank's Strategy To implement their strategy, commercial banks rely heavily on financial markets. (Exhibit 19.1)